Peter McGahan: What is an inheritance tax loan trust?

I covered inheritance tax two weeks ago, but paused for a self-indulgent rant about COP26 last week.

In the meantime, I had a few more questions about inheritance tax – one of which was how to freeze the value of an estate to prevent an inheritance tax problem from getting worse as the Stock markets and house prices are skyrocketing.

Inheritance tax is that large 40 percent levied on part of your estate after taking into account the corresponding allowances. It’s not very popular, especially when compared to a good glass of wine, or a vacation for example.

One obvious choice is to donate our excess income each year, as this falls under gifts outside of normal expenses. If you have excess income, you can donate as long as it is regular and the transferor has enough income to maintain their normal standard of living. In addition, you have the advantage of seeing the children benefit from the gift. Nice feeling of blur.

For larger sums, or even the idea above, there is the risk that the kids will marry someone you just don’t trust. You know the feeling.

There are many options available, but a reader asked about a loan trust, so I’ll cover that.

Don’t be fooled by the word “trust”. It is simply a legal document used by many people with the aim of reducing both inheritance tax and rapid access to capital in the event of death.

A loan trust would normally be used for people who initially want to start estate tax planning, but are afraid or not ready to give up capital and still want to keep some income from it.

How does a loan trust work? First, you hire an independent financial advisor, lawyer, or accountant to set up a trust for you. You then lend money to the trust and appoint your trustees (your advisers do all of this for you). Trustees (the people you appoint who will ensure that the trust is executed properly) now invest this money as you wish and for the ultimate benefit of the beneficiaries (to whom you want the money to go).

You can then set up a loan repayment from the trust at the rate of a five percent tax deferred withdrawal and paid to you. However, any growth in the fund is outside of the estate, so if the fund chosen by the trustees has performed well, it is not part of the estate at all, capping any future growth.

When you withdraw “income” (repayment of your loan) from the trust in accordance with the loan agreement and spend it, that capital comes out of your estate. If you decide to take back the entire loan at any time, you can do so, leaving the growth to the beneficiaries.

You can set up two types of trusts: an absolute trust and a discretionary trust.

With absolute confidence, you indicate the beneficiaries and their rights at the outset and cannot change them. The beneficiaries of an absolute trust can, after 21 years, request access to the value of the growth part of the fund.

With a discretionary trust, the settlor (the person who creates the trust) can change the beneficiaries at any time and what they are entitled to (see questionable boyfriend point above). Under a discretionary trust, however, there could be an ongoing tax burden. On the 10th anniversary, if the value of the trust is above the zero rate band at that time (currently £ 325,000), a periodic fee will be payable.

Disadvantages? When you pay off the loan – it’s 20 years if you take 5 percent – you no longer have any benefits since the loan has been paid off. Of course, you don’t have access to growth either, but that was the point – freezing that part of your estate.

Be careful who invests the underlying capital. Setting up a trust is easy, but the difference in cost and performance in the underlying money can be wiped out in a matter of years if you don’t have a quality manager looking after your money.

Peter McGahan is Managing Director of independent financial advisor Worldwide Financial Planning, which is authorized and regulated by the Financial Conduct Authority. If you have questions about inheritance tax, call Darren McKeever on 028 6863 2692, email [email protected] or visit wwfp.net.


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